The ability to achieve political reforms in the eurozone

The reasons for the issues in the eurozone are long-term in nature. The current debt problems in the European Economic and Monetary Union (EMU) are only an indirect result of a cyclical crisis; instead, they revealed existing untoward developments.

Numerous reforms are needed. The image of the eurozone in 2012 and beyond will be determined by both fiscal austerity measures and structural reorganisation in other policy areas. The question is whether these undertakings can be implemented efficiently and sustainably.

Institutional and political framework conditions play a crucial role in determining the ability of eurozone countries to achieve reforms. The quality of government performance and administrative systems was below average particularly in southern European countries. This underperformance has consequences for the macroeconomic performance of these countries, impacting on factors such as the level of government debt and competitiveness. It appears that countries that are more capable of achieving reforms have greater macroeconomic stability.

The form of government in the countries has only a limited impact on the ability to achieve reforms. According to critical assessments neither centralised nor decentralised decision-making structures are per se more suitable for implementing reforms. The decisive factors are the number of political bodies within the reform process as well as their bargaining power.

Sources: Worldbank, World Economic Forum, DB Research

Current situation

During the financial crisis the level of new debt increased significantly in many countries. The financial crisis by itself cannot explain the current debt problems in the EMU countries. Even in the final stage of the Great Moderation, sovereign debt was not reduced extensively, with the exception of Ireland and Spain (chart 1). Long-term structural conditions usually trigger current economic problems. That is why numerous reforms are necessary. Policymakers are faced with a balancing act. On the one hand, steps to prevent economic downturns have to be taken to promote growth and stabilize new borrowing. On the other hand, structural reforms must boost competitiveness in order to guarantee sustained economic growth.2 The question arises: How capable of reform are the countries in the eurozone?

Discussions about reforms are well underway in Rome, Madrid, Lisbon and Athens. Gaining parliamentary approval for reforms is not the only important factor, their actual implementation is also crucial. Well-functioning political and institutional framework conditions are prerequisites for a country‘s ability to achieve reforms. In this context it is logical to ask the following questions and search for answers:

How efficiently does a government work?

How can the regulatory quality of an administration be assessed?

Are centralised governments more reform-friendly than decentralised governmental structures?

We shall seek to demonstrate that the ability to achieve political reforms determines the macroeconomic stability of each EMU country. The political ability to reform is explained by the success factors which are defined by the central political bodies (chart 2). The factors analysed below will be the quality of government performance and administration as well as the influence of the form of government.

Quality of government performance

Governments prepare and implement reforms – with parliamentary legitimation. Even though the political process may differ from one eurozone country to the next, one thing they have in common is that the quality of government performance is crucial for the successful implementation of reforms. In turn these reforms are the prerequisite for macroeconomic stability in many countries. The question is: how can we measure or evaluate quality? In this case, we will focus on two criteria: efficiency and effectiveness of government performance.

Key factor: Efficiency

Efficiency is a measure of the volume of resources required to achieve an objective. The economic costs incurred to attain a certain objective are to be kept to a minimum. In this instance the cost-benefit ratio arises from the resources deployed to implement a given reform (output). Efficient government operation is defined as implementing desired reforms at minimum cost. The current debt ratios in the eurozone make targeted and cost-effective implementation of reforms particularly desirable. In practice government efficiency can only be approximated. The main reason why is that the public sector, unlike the private sector, produces only a limited quantity of market-oriented products or services, thus making a monetary valuation of government performance in terms of market prices only possible to a limited extent.

Indicators are mostly used to approximate and get an idea about the general performance orientation.3 The World Economic Forum (WEF) developed one of these indicators. It consists among other things of wasted public spending, regulatory burdens for the private sector, efficiency of legal framework conditions and transparency of legislation. Governments are the key determinants of these factors.

Looking at the eurozone

The performance orientation of a government within the eurozone and its debt are interdependent. Countries with highly efficient governments tend to have lower debts and vice-versa. Chart 3 illustrates this correlation. Finland, the Netherlands and Austria are among the front runners. By contrast, it is exactly those countries currently having to contend with financial problems that find themselves at the back of the pack. An illustration of debt development confirms the assessment of efficient government performance of the countries (chart 4). This outlook is quite pessimistic for the efficient implementation of the necessary reforms in southern European countries. Improved government performance is a prerequisite for reducing new borrowing and thus also the debt ratio in the long-term. Well-functioning governmental structures are essential for debt reduction.

Innovation in an economy significantly impacts the long-term growth path.4 One objective of public policy is therefore to create the conditions for innovation. Here, too, suitable framework conditions which reflect successful government performance are required in order to successfully realise innovations. Chart 5 compares government efficiency with the capacity to innovate. The WEF indicator for innovative capacity consists of the quality of scientific institutes, the private and public involvement in research and development as well as patent applications. The north-south disparity can be confirmed in this case as well.

Looking at the ease of doing business (chart 6, next page), which is also relevant for the competitiveness of a given country, reinforces this assessment. However, Portugal performed much better than had been expected on the basis of previous indicators. Seemingly, Portugal has created the prerequisites for a cost-efficient economy. The country has well-developed insolvency legislation. The recovery rate of 70.9% per dollar spent in case of company insolvency is significantly higher than the 53.8% in Germany. Nations capable of achieving reforms are more innovative, pro-business, and therefore more competitive in the long-term. They are more likely to meet the challenges of addressing low debt levels and long-term stable economic growth.

Key factor: Effectiveness

The implementation of reforms is highly dependent on governments‘ willingness to rigorously execute the proposed legislative restructuring. Only if economic and social bodies are able to rely on declarations of intent by governments, can reforms be implemented and private investment decisions be made in a sensible way. Mistrust, by contrast, complicates the entire process. In turn a government‘s reliability depends significantly on the public perception of the quality of government performance – with regard to both formulation and implementation.5The World Bank has included these reform prerequisites in its indicator of government effectiveness. In contrast to efficiency as described earlier in this text, effectiveness reflects the relation between the objective achieved and the defined objective. Resources used only play an indirect role. Working effectively is defined as working in such a manner that an output is generated.6 In this case the all-important output is the reform outcome. Government effectiveness thus expresses the relationship between actual and desired government performance, also with respect to reforms, among other things. The question arises: How much does the reform results differ from the drafted law?

A look at the eurozone

In terms of government effectiveness, Finland outperforms Germany and France by far, while Italy and Greece are the poorest performers (chart 7). Europe is thus currently also divided on this indicator; there are, however, numerous countries worldwide whose performance is much worse, which puts the disparity into perspective. Developments in the past decade show that effectiveness decreased especially in the big eurozone countries, most of all Spain. This is problematic. Effectiveness of government performance is a crucial aspect of reform capability. Particularly in view of forthcoming reform projects, a reliable quality of governance may be essential for structural improvements. Building and maintaining trust hinges on the success of forthcoming reforms.

The role of the state in business

A recurring proposal to reduce government debt and generate competitiveness is to reduce public-sector economic activity. This implies a negative correlation between the level of government spending and economic growth. This view is also supported by economic theory that public spending crowds out private investments. Another response to the statement above is that minarchism cannot be a solution in present times, since state provision of public goods like infrastructural facilities, especially for education, stimulates growth. The law of falling marginal utility holds true for the provision of public goods. Consequently, this means that taken as a whole and theoretically there is an optimal point for the extent of government activities. If government activities are extended beyond that point, growth is no longer stimulated but slowed down. A universal ratio of government expenditures to GDP at which this point is reached cannot, however, be determined.7 The first impression provided by data about growth and ratio of government expenditures to GDP is as follows (chart 8): since 1999, growth does not seem to be dependent on the extent of state involvement in the economy. This means it is probably more important which activities the state performs and how successful it is in doing so. The case of Finland shows that contrary to widely held views a high ratio of government expenditures to GDP can be accompanied by high growth rates. In addition, no conclusions can be drawn about effectiveness of government performance from the volume of government activity (chart 9). It cannot be said that ―rolled back‖ states per se are more effective. In the context of reform implementation it should be noted that effective government performance which can better implement reforms and generate growth, cannot automatically be achieved by reducing the ratio of government expenditures to GDP. Rather, it is a matter of which activities are curtailed.8 A state‘s withdrawal from economic activities, especially in the area of providing public goods, should therefore be well thought through.

Quality of public administrations

Besides governments, public administrations also play a crucial role in implementing reforms. Even though administrations have to comply with legal requirements when implementing reforms, they must also fulfil two major tasks: firstly, administrations have to close the margin for interpretation in the spirit of the law. Secondly, they have to implement the reforms fast and use resources efficiently. The reform capabilities of individual states can therefore be analysed by using the quality of the bureaucracy.

Key factor: Regulatory quality

A key prerequisite for well-functioning administrative structures is a constant flow of communication internally as well as externally. In practice this means the provision of data about the activities of the government, the business sector and the society as a whole. The results are transparency for investors and acceptance from society which in turn will then be a necessary prerequisite to remain competitive. Only when administrations are sufficiently accountable can their activities be monitored transparently and incentives exist for efficient actions.9 It is precisely this aspect that was criticised by the OECD report on Greece.10 Another key requirement is the interconnectivity of different administrative levels using well-developed information and communication technologies. The information exchange minimises duplication and reduces mistakes when executing reforms due to a better internal and external coordination between the administrative levels. This information exchange coupled with competent and agile staff enables public administrations to implement reforms successfully. In turn the quality of administrations has an impact on the macroeconomic stability of a country. Administrations not only directly influence the regulatory and institutional economic environment but thereby also impact the business climate substantially. The business climate is of great importance for economic growth. In the course of structural reforms this should be kept in mind.11

A look at the Eurozone

The World Bank has investigated the regulatory quality of governments worldwide; chart 10 illustrates the results. The index consists among other things of the ability of administrations to coherently implement reforms which serve the business climate. From a global point of view, the eurozone performs very well when it comes to implementing reforms, however, two developments should be noted: firstly, the regulatory quality in France for private sector development has increased significantly since 2000. Secondly, a clear disparity persists between northern and southern Europe. This leads to the conclusion that well-functioning administrative structures promote the development of the private sector.

Administrative costs

According to the OECD there are additional requirements for a functioning administration: the structure of the public administration should be lean and hierarchically centralised with clearly separated responsibilities. Furthermore, an administration should have both an ex ante and ex post legally binding financial framework to prevent an exponential increase in costs.12 The largest financial item within an administration is constituted by personnel expenditures. Chart 11 illustrates the development of wages and salaries in public administrations. The chart clearly shows that the wages in Italian, Greek and Spanish administrations increased significantly since 1999. By contrast, wages in Germany only increased slightly. Consequently, these high administrative expenditures heap additional costs onto the already heavily indebted countries.

One explanation for the cost increase can be found in economic theory. The phenomenon known as Baumol’s cost disease states that labour productivity in the public sector is more difficult to be substituted with capital than for instance in the manufacturing industry, assuming that the quality stays the same.13 Furthermore, wages should increase with productivity. The scope for productivity growth in the administrative area is limited, however, and increases more slowly than in other sectors of the economy. In order to avoid enormous wage disparities and the associated staff turnover, the wages and salaries in administrations as well as the general pay level increase at similar rates. Chart 12 reflects this correlation. In comparison with other countries in the eurozone, Germany‘s economy as a whole posted a small increase in wages and salaries. This also held true for administration. However, its costs are constantly rising relative to value creation because of the lower productivity growth. Consequently, public administrations are becoming more and more expensive.

Expenditures on public administrations measured against total government expenditures can be used to examine whether a cost explosion has occurred (chart 13). Once again there is a disparity between northern and southern Europe; however, this time in reversed order. Portugal, Greece and Spain in particular managed to reduce their expenditures by an average of 20% since 1999, while Finland and Germany recorded a relative increase in costs. However, the chart cannot show whether the cost reduction is due to a contraction in the employment structure or a more efficient spending policy. On top of this, as with every relative variable, changes do not just have a single cause. For instance, if total government expenditures increase more than the administrative costs, then the relative portion for costs of public administrations decreases in comparison to total government spending. A look at the development in total government expenditures highlights two trends: since 2007, all states have been spending significantly more due to the crisis and Greece and Portugal show the highest increase in spending (chart 14, next page). This puts into perspective the development of administrative spending relative to total government expenditures. Against this backdrop it should be noted that the Baumol’s cost disease, which seemed to be present in the wages and salary development, is apparently not reflected in a cost explosion. Among other things this is due to increasing digitisation and as a result increasing efficiency of public administrations.14 Government expenditure could decrease significantly if the administration levels were downsized drastically; however, this could also reduce a country‘s reform capabilities. Reform implementation requires suitable personnel and the appropriate administrative prerequisites, so that too much shrinkage in administrations would have a negative impact on reform capacities. Every country is different and therefore this appraisal process should be addressed individually. The long-term structural stability of public administration should not be sacrificed for short-term debt reduction.

Influence of form of government

The form of government determines the number and negotiating power of political bodies in decision-making processes. It can be decisive in implementing reforms, not only for the timing but also for the depth of structural changes. How much influence do decision-making structures have on the ability to achieve political reforms? The following paragraphs analyse whether the form of government is per se critical for implementing reforms; there are basically two lines of argument.

Firstly, it is assumed that a greater number of political bodies complicate, delay or prevent reform plans. This is based on the assumption that a greater number of political bodies make the array of relevant and also contradictory interests more complex. It is important to unite multiple interests. Even though reform “losers” can be compensated for potential losses, this still complicates negotiations. From this perspective, centralised states in which the regions play a subordinate or only implementing role have an advantage. Centralised governmental structures eliminate regions as rainmakers and thus also numerous potentially diverging regional interests. Although reforms can be adapted regionally, negotiations involving a supposedly smaller number of participants are more likely to reach an (efficient) solution.15 Therefore, it might be argued that centralised or even unitary states implement reforms quicker and more efficient than federal states.

France has a centralised governmental structure. After parliament approves a reform package it is forwarded to the Départements. The Départements are headed by prefects appointed by the Ministry of the Interior, so that reforms have fewer steps to pass through before their implementation. The situation is different in Germany, for example. On the one hand, Germany‘s constituent federal states (Länder) are actively involved in the decision-making process in the Upper House of the German Parliament (Bundesrat) due to their own regional competences. Particularly if the majorities in the Bundesrat are different from those in the Bundestag (Lower House of the German Parliament), it can lead to a more or less protracted delay in political decision-making. On the other hand, the German executive federalism ensures that reforms which are accepted and approved by both houses are generally also accepted by the executive bodies of the Länder and can therefore be implemented more swiftly. The two lines of argument mentioned above show that the number of policymaking levels and bodies that are part of reforms do not automatically determine the speed and quality of reform implementation.

Besides the sheer number of political bodies, the bargaining power of individual decision-making levels can play a crucial role. If a political body has almost monopolistic power and many other political bodies have modest negotiating clout, the powerful political body will always prevail. Unless, all individual political bodies join forces and thereby gain more bargaining power than the one powerful political player or they account for the majority in a given electoral system.16 The Comunidades Autónomas in Spain, Regioni a statuto speciale in Italy and the Bundesländer in Germany are examples of relatively powerful second-level political bodies. Firstly, these decentralized authorities impact national decisions and secondly, they handle the majority of their affairs on their own. Chart 15 shows the decentralized authorities‘ proportion of total government debt. Especially in the case of Germany this is certainly due to the cost intensity of expanded competencies.17 In the context of reform capabilities this means that decentralised decision-making structures are mostly accompanied by differences in negotiating power. Regional affairs can thus be handled in a decentralised way; however, this also implies a more complex weighing-up of different interests at the national level.

Conclusion

EMU countries were analysed on their capability for achieving political reforms based on the quality of their government performance and public administrations as well as on the influence of their form of government. It has become apparent that reform capacities depend significantly on the quality of government performance – the higher the quality, the greater the reform capability and the macroeconomic stability. The quality of public administrations is essential as well. On the one hand, countries with a well-functioning and business-friendly administration are currently in a better position. On the other hand, it should be noted that not only the level of administrative costs is responsible for the debt ratio but also how efficient and effective the budget is used. States with greater capacities for reform enjoy greater macroeconomic stability.

Based on the analyses it can be stated that, the high debt and the lack of competitiveness of some southern European countries are due among other things to inefficient structures of government operation and public administration – structures that hamper reform plans. In order to become more capable of political reforms and more stable economically in the future, some structural changes in these areas are inevitable. “Technocratic” governments could be a temporary solution for some countries to achieve this objective. First and foremost the basic principle should that it is not necessarily less state, but rather more efficient administrative structures that can help to solve problems. On a long-term perspective, Europe can only remain united in diversity if the ability to achieve political reforms is guaranteed.

Footnotes:

[1] Ireland poses an exception to this. The country itself has for the most part well functioning structures, but had to provide a high level of support to its bank sector during the financial crisis. Ireland‘s debt level increased from 25% of GDP in 2007 to 107% in 2011. The high level of government debt is therefore primarily due to the bank bailout rather than weak structural conditions.[2] See Quantification of growth: Hobza/Mourre (2010). Quantifying the Potential Macroeconomic Effect of the Europe 2020 Strategy: Stylized Scenarios. European Economy Economic Paper No. 424. European Commission. For more information see Allard/Evaraert (2010). Lifting Euro Area Growth: Priorities for Structural Reforms and Governance. IMF Staff Position Note.[3] See European Commission (2008). European Economy – The Effectiveness and Efficiency of Public Spending. Economic Papers 301.[4] The economic literature about the influence of innovation on growth is enormous. Two interesting examples: Schumpeter (1943). Capitalism, Socialism, and Democracy. Routledge; and Acemoglu (2009). The Crisis of 2008: Structural Lessons for and from Economics.[5] OECD (2009). The Political Economy of Reform. Lessons from Pensions, Product Markets and Labour Markets in Ten OECD Countries. OECD Publishing.[6] See European Commission (2008). European Economy – The Effectiveness and Efficiency of Public Spending. Economic Papers 301.[7] See Österreichisches Institut für Wirtschaftsforschung (2008). Effizienz der Ausgabenstrukturen des öffentlichen Sektors in Österreich.[8] One option to reduce debt presents privatisation of suitable activities. See Bräuninger/Steimer (2011). Revenue, competition, growth: Potential for privatisation in the euro area. Deutsche Bank Research. EU Monitor 87. December 1, 2011.[9] Jacobzone/Choi/Miguet (2007). Indicators of Regulatory Management Systems. OECD Working Papers on Public Governance 2007/4. OECD Publishing.[10] OECD (2011). Greece: Review of the Central Administration. OECD Public Governance Reviews. OECD Publishing.[11] See OECD (2010). Making Reform Happen: Lessons from OECD Countries. OECD Publishing.[12] Meloni (2010). Enabling Regulatory Reform, in: Making Reform Happen: Lessons from OECD Countries. OECD Publishing.[13] See Baumol/Bowen (1966). Performing Arts: The Economic Dilemma; a Study of Problems Common to Theater, Opera, Music, and Dance. Twentieth Century Fund.[14] See EU activities and national eGovernment programs: eEurope (until 2005); Initiative i2010; Digital Agenda for Europe; eGovernment Österreich.[15] See (although in a different context): Coase (1960). The Problem of Social Cost, in: Journal of Law and Economics. Vol. 3. S. 1-44.[16] More information about distribution of bargaining power: Ishiguro (2008). Political Reform, Incentives and International Intervention: An Incomplete Contracts Approach. Kobe University Economic Review 54, pp. 35-53.[17] For more information about this topic, see Zipfel (2011). German finances: Federal level masks importance of Länder. Deutsche Bank Research. Current Issues. May 27, 2011.